View this article as a PDF file
Libey Incorporated
Economic Outlook
Secrets of the Catalog Master
Vol. MMV No. 3 May 2005
Advisors and Intermediaries To The Catalog Industry
Philadelphia, Pennsylvania
Donald R.
Libey, Editor
Lifetime Value
by Donald R. Libey
Recently, I have completed forensic audits on three multi-channel direct marketing companies for their owner, investment group or parent corporation. In all three instances, neither the CEO nor any of the senior managers knew the lifetime value of their customer. This is not surprising. Many people have come to the direct marketing world in recent years from other endeavors and simply have not been exposed to the precise formulaic measurements that support our world. Additionally, the present focus on measurements related to the online channel has made such an old-fashioned concept as lifetime value seem obsolete. Au contraire! Lifetime value retains its position as the Prime Measurement.
Preliminary Definitions
The first thing I want to stress is that lifetime value cannot be understood until the cost to acquire a customer is understood. Measuring the cost to acquire a customer is a complex calculation dependent upon the direct marketing methodology. A one-step acquisition, as with a list rental or a space advertisement requires one method of calculation. A two-step involving lead generation and conversion of inquiries requires a second calculation. The cost to acquire a customer is one of the Mother Measurements in multi-channel direct marketing.
The term ‘lifetime value’ is often associated with several other ‘lifetime’ terms that should be mentioned. Lifetime spend is the total amount a customer will spend with you over their life, also called sales. It should not be confused with value, which is a derivative of sales. Lifetime profit is a confusing term that should be further qualified by either gross profit, profit contribution or net profit. Gross profit is sales less cost of goods. Profit contribution is sales less cost of goods, cost of advertising and fulfillment. Net profit is sales less cost of goods, advertising, fulfillment and overhead. Lifetime value—correctly—is profit contribution multiplied by the time value of money discount factor, which produces the net present value, or the value today of profits to be gained in the future.
The second thing I want to stress is the definition of ‘life.’ Most direct marketers have customers that have been buying from them for years. The owners believe all of their customers are similarly loyal. They’re not. Best case, life is a measured and known average length of time that a customer is active. Worst case, life is a time-limited amount of time that can be justified, such as three years. In the first instance, the company actually knows the life span of their customer. In the second, the company does not actually know but makes a logical assumption based on experience. In a business where fractions of a percentage point can product huge gains or losses, it isn’t too difficult to figure out why actually knowing the exact life is preferred to assuming.
The third thing I want to stress is that lifetime value is different depending on the channel. The life of a catalog customer may be different from the life of an online customer. But, while they are likely different and require calculations by channel, the overall life of a customer is inclusive of all channels. At some point, we have to get to one number in order to be relevant. To get to one number representing life, however, we have to know all life numbers by channel. And, to get there, you have to be able to attribute a source for all customer acquisition and for all orders by channel.
The fourth thing I want to stress is that there is no acceptable ‘normal’ cost for the cost to acquire a customer, customer life or lifetime value. They all depend on variables such as industry, gross margin, acceptable return on investment, whims of the owners, and so forth. One company will pay more to get a customer because they expect to have that customer longer, or because the gross profit is 72 percent, or because the average order value is $4,200. The point: These are individual calculations for individual situations.
Finally, while knowing lifetime value today is critical, knowing lifetime value next year and two years from now is genius. The only way to predict that is to be able to track lifetime value over time and ‘see’ the trend. The visual trend is only understood on a classic x and y axis chart. The minimum amount of tracking time to accurately understand and see the lifetime value trend is twenty rolling quarters or five years of history. Rolling quarters describes a period of the last five years always moving through time; the oldest quarter drops off when the newest quarter is added to the chart.
Lifetime Value
Lifetime value is the value today of the profits to be gained in the future from a specific group of customers. Another way of looking at this is lifetime value is what the customers are worth today for their expected performance over time. A third, somewhat crude, way of stating lifetime value is, “What’s in it for me? If I spend money to get a customer, how much do I get back along with some interest for using my money?” Right away, you can see that the lifetime value process excites a direct marketer and the lifetime value number either excites or turns off an investor. Lifetime value is, therefore, an operating measurement and an investment measurement.
Begin with a group of customers either from one source or channel or from a variety of sources or channels. That selected group of customers will be tracked through the three years, or all customers can be tracked through the three years. By determining a selected group for lifetime value analysis, you can choose to track, for instance, all catalog customers, all online customers, all DRTV customers, all space ad customers, and so on. Similarly, you may choose to track all customers from response lists, or from compiled lists, or from co-op lists, or subscriber lists, or email lists. Some may want to do zip code lifetime value, or geographic lifetime value, or who knows—customers attracted on phases of the moon, or Tuesdays—whatever. Most of us, however, tend to need: 1) an overall customer lifetime value; 2) an overall channel lifetime value; and 3) an overall source lifetime value. For the advanced multi-channel direct marketer, lifetime value by recency, frequency and monetary value (RFM) segmentation is essential. Some business-to-business marketers also require lifetime value by Standard Industrial Classification (SIC). The point: There are many lifetime values and you will benefit from a variety of views; however, until you can accurately do one overall lifetime value, don’t get weird.
Lifetime value offers the CEO of any multi-channel direct organization a multi-variate tool with which to begin the process of financial optimization. For some, lifetime value is the calculation that precedes all others. A focus on sales reveals response and retention; a focus on costs reveals operational and channel/media efficiencies; a focus on profits reveals the relative effectiveness of the entire business above the overhead line, which is the dynamic portion of the company. Whatever factors are right or wrong about a multi-channel direct marketing company, I can almost always get to the heart of the matter via the lifetime value calculation. For me, it’s the Mother Calculation, the Béchamel Sauce from which all other sauces emanate.
The following chart provides a synopsis of the lifetime value calculation. The percentages and values are hypothetical, but reasonable for direct marketing organizations. Gross profit, advertising and fulfillment costs will vary from company to company. While both advertising and fulfillment are important, the critical variables in lifetime value are retention and gross profit. If retention can be improved only slightly, or if gross profit can be increased only slightly, the lifetime value is improved dramatically. In the future, the impact of online technologies and costs will have a much more significant effect on both advertising and fulfillment costs, particularly as automated processes replace labor-intensive systems.
Please note that this is not a full discussion of the complete suite of value calculations, which include: 1) lifetime value; 2) net present value; 3) internal rate of return; and 4) payback. These four are used by boards of directors as the minimal calculations necessary to evaluate the potential of an investment. In this example, the time value of money discount factor is 20 percent, a common rate for the direct marketing industry; however, the rate can be higher or lower depending on numerous variables.
| Lifetime Value Calculation
|
First Year
|
Second Year
|
Third Year
|
| Sales
|
|
|
|
| Customer Group
|
1000
|
500
|
300
|
| Customer Group Retention Percentage
|
50%
|
60%
|
70%
|
| Sales per Customer
|
$400
|
$400
|
$400
|
| Total Sales
|
$400,000
|
$200,000
|
$120,000
|
| Sales
|
|
|
|
|
|
|
|
|
| Costs
|
|
|
|
| Gross Profit
|
50%
|
50%
|
50%
|
| Cost of Goods Sold
|
$200,000
|
$100,000
|
$60,000
|
| Fulfillment Percentage
|
12%
|
12%
|
12%
|
| Fullfillment Cost
|
$48,000
|
$24,000
|
$14,400
|
| Advertising Percentage
|
25%
|
25%
|
25%
|
| Advertising Cost
|
$100,000
|
$50,000
|
$30,000
|
|
|
|
|
|
| Profits
|
|
|
|
| Contribution to Overhead
|
$52,000
|
$26,000
|
$15,600
|
| Time Value of Money Discount
|
20%
|
20%
|
20%
|
| Net Present Value
|
$43,333
|
$18,056
|
$9,028
|
|
|
|
|
|
| Customer Lifetime Value ($ ÷ 1,000)
|
$43.33
|
$18.06
|
$9.03
|
| Cumulative Customer Lifetime Value
|
$43.33
|
$61.39
|
$70.42
|
A primary use for lifetime value is to establish how much a direct marketing company is willing to spend to acquire a new customer, or the level of investment prospecting. Logic tells us that if the cost to acquire a customer in the first year is $70.42, this idea isn’t going to work out well. And don’t forget, the above is only calculated to the contribution to overhead line. Knowing the cost to acquire a customer at the source level is essential. Source includes not only lists, but also search engine sourcing, including organic, pay-per-click, pay-per-sale, affiliate, and all other forms of online new customer acquisition. Each of these sources is examined, first for cost to acquire and second for lifetime value. A hierarchical comparison is made for cost to acquire and lifetime value, and a subsequent correlation produces the optimized source + cost to acquire + lifetime value ranking.
Responsibility for Lifetime Value
Everyone in the company has a stake in customer lifetime value, but there are two positions that have the responsibility for accuracy and application of lifetime value to management: the CEO and the CFO. Lifetime value is a ‘rudder’ analysis; it keeps the ship on course and it takes a long time to swing the bow a few degrees to port or starboard. The CEO has to give the orders; the CFO has to execute those orders. Everything concerning lifetime value is determined by response rates, cost of goods, advertising costs, fulfillment costs, and the proper determination of the time value of money and the risk associated with the investment.
Next Page
Pages: 1 2
3
